Parker-Hannifin Corporation (NYSE:PH) has significant opportunities to expand its operating margins, especially within the Aerospace segment where significant longer term business has already been won, and aftermarket opportunities should increase.
With annual sales of $13 billion in fiscal year 2013, Parker Hannifin is a diversified manufacturer of motion and control technologies and systems, providing precision-engineered solutions for a wide variety of mobile, industrial and aerospace markets. It employs approximately 58,000 people in 49 countries around the world.
Aerospace is the company's strongest unit with commercial leading the way. Parker has won more than $26 billion in new business (to be converted to sales over a long period) in the past year or two. This means that growth is relatively assured, but development expenses are still relatively high and have started declining.
Aerospace margins are expected to peak near 17 percent versus the current 12.5-13 percent.
"As the R&D expenses dissipate and the lower margin OEM business matures, aerospace segment operating margins should continue to move ahead," BMO Capital Markets analyst Joel Tiss wrote in a note to clients.
Outside of the Aerospace segment, the automotive end market remains strong as does farm and agricultural equipment-related markets and distribution (about 55 percent of total Parker sales go through distribution).
On the weak side are construction equipment, oil & gas equipment (natural gas is soft with oil stronger but not great), and process industries owing to petroleum-related products. Military aerospace is sluggish from continued budget cuts, and Parker has seen some weakness in life sciences, as well.
There is a formal plan to add 200 basis points (bp) to segment operating margins to bring the entire company to at least 15 percent by 2016. This 200 bp improvement will largely come from four key areas, each approximately having the same total impact: Aerospace, Europe, in! novative products, and driving the WIN strategy.
Aerospace: A conservative 50 bp of incremental total company operating margin is expected to come from the above factors. There is at least 300 bp of margin improvement in front of the Aerospace division, but given this segment only accounts for about 17 percent of total Parker sales, the total impact comes to the 50 bp.
"Here (Aerospace), the business is already won, so all that Parker needs to do is execute – which is a core strength of this company," Tiss noted.
Europe: Another 50 bp is expected to come from Europe, where Parker is aggressively implementing another round of plant closures, workforce reductions, and other synergies (like shared services, purchasing, focused factories, etc.). The goal is to take segment margins over 15% assuming no end market growth.
In 2003-2005, the largest investor complaint against Parker was about its European operating margins, which had never cracked the double-digit mark. Parker undertook a massive restructuring and cost-cutting effort, which pushed segment margins to 15.8 percent in 2008.
The current drive to grow European operating margins is just an extension of the last restructuring effort and is more about more focused manufacturing and better purchasing than a brute force capacity/people reduction.
Innovative products: The next 50 bp is expected to come from innovative products, which has been a strategy for the past five to six years, and many of initiatives to deliver products that are new to the market and new to the world has begun to spit out a slew of innovative products.
"There are some small acquisitions and licensing agreements that are supplementing the internal new product pipeline to deliver 4% of sales from new and innovative products. These products are truly unique and carry growth, margins, and pricing well above Parker's highest levels," Tiss said.
The last 50 bp should come its continuing drive of the WIN strategy, which will never go o! ut of sty! le at Parker. The basic tenants of WIN such as lean manufacturing, strategic pricing, better procurement, on-time delivery, maximizing RONA (returns on net assets), etc., are drivers that can never be perfected but align employees and managers to maximize profitability and free cash flow.
Over 90 percent of total company employees are on an incentive/profit sharing program that drives bonus awards through free cash flow generation, RONA, operating margins, and profitable growth, which has been a strong driver of continuous improvement at all Parker operations globally.
"With some 55% of total sales going through distribution and the diversity of end market exposure, we believe that the cyclicality of the entire company is lower than for most other industrial companies," Tiss said.
Moreover, the focus on dividends, new product introductions, acquisitions, and share repurchase is not likely to wane as free cash flow remains well in excess of net income, and the balance sheet is extremely clean.
The company's growth plans and margin improvement initiatives are solid and achievable. Margin improvement from the aerospace division seems to be almost certain as $26 billion of new business has been won recently, and as the R&D spending turns into revenues and earnings costs decline as profits improve.
"Even five or more years down the road, margins should have a further upward bias as OEM mix is complemented by more aftermarket opportunities," Tiss added.
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